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Saving, Investment, and the Financial System Chapter 13 Copyright © 2001 by Harcourt, Inc. All rights reserved. Requests for permission to make copies of any part of the work should be mailed to: Permissions Department, Harcourt College Publishers, 6277 Sea Harbor Drive, Orlando, Florida 32887-6777. Saving and Investment in the National Income Accounts Recall that GDP is both total income in an economy and total expenditure on the economy’s output of goods and services: Y = C + I + G + NX Some Important Identities Assume a closed economy – one that does not engage in international trade: Y=C+I+G Some Important Identities • Now, subtract C and G from both sides of the equation: Y – C – G =I • The left side of the equation is the total income in the economy after paying for consumption and government purchases and is called national saving, or just saving (S). S=I Saving and Investment • For the economy as a whole, saving must be equal to investment. S=I The Market for Loanable Funds Financial markets coordinate the economy’s saving and investment in the market for loanable funds. The Market for Loanable Funds Loanable funds refers to all income that people have chosen to save and lend out, rather than use for their own consumption. Supply and Demand for Loanable Funds • • The supply of loanable funds comes from people who have extra income they want to save and lend out (savings). The demand for loanable funds comes from households and firms that wish to borrow to make investments (borrowing) . Supply and Demand for Loanable Funds • • • • The interest rate is the price of the loan. It represents the amount that borrowers pay for loans and the amount that lenders receive on their saving. The interest rate in the market for loanable funds is the real interest rate. The equilibrium of the supply and demand for loanable funds determines the real interest rate The Market for Loanable Funds Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. An Increase in the Supply of Loanable Funds... Interest Rate Supply, S1 S2 1. Households decide to save more of their income. 5% 4% Demand 2. ...which reduces the equilibrium interest rate... 0 $1,200 Loanable Funds $1,600 (in billions of dollars) 3. ...and raises the equilibrium quantity of loanable funds. Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. An Increase in the Demand for Loanable Funds... Interest Rate 6% 5% 2. ...which raises the equilibrium interest rate... 0 Supply 1. Businesses decide now is a good time to invest in plants & equipment D2 Demand, D1 $1,400 $1,200 Loanable Funds (in billions of dollars) 3. ...and raises the equilibrium quantity of loanable funds. Taxes and Saving •Taxes on interest income substantially reduce the future payoff from current saving and, as a result, reduce the incentive to save. The result will be higher interest rates and smaller investment •If a change in tax law encourages greater saving, the result will be lower interest rates and greater investment. Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. An Increase in the Supply of Loanable Funds... Interest Rate Supply, S1 S2 1. Tax incentives for saving increase the supply of loanable funds... 5% 4% Demand 2. ...which reduces the equilibrium interest rate... 0 $1,200 Loanable Funds $1,600 (in billions of dollars) 3. ...and raises the equilibrium quantity of loanable funds. Taxes and Investment If a change in tax laws encourages greater investment (a reduction in the capital gains tax), the result will be higher interest rates and greater saving. Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. An Increase in the Demand for Loanable Funds... Interest Rate 6% 5% 2. ...which raises the equilibrium interest rate... 0 Supply 1. An investment tax credit increases the demand for loanable funds... D2 Demand, D1 $1,400 $1,200 Loanable Funds (in billions of dollars) 3. ...and raises the equilibrium quantity of loanable funds. Some Important Identities • National saving, or saving, is equal to: S=I S=Y–C–G S = (Y – T – C) + (T – G) Private Saving • Private saving is the amount of income that households have left after paying their taxes and paying for their consumption. Private saving = (Y – T – C) Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. An Increase in the Supply of Loanable Funds... Interest Rate Supply, S1 1. A decrease in personal income taxes increases the supply of loanable funds... Demand 5% 4% 2. ...which reduces the equilibrium interest rate... 0 S2 $1,200 Loanable Funds $1,600 (in billions of dollars) 3. ...and raises the equilibrium quantity of loanable funds. Public Saving • Public saving is the amount of tax revenue that the government has left after paying for its spending. Public saving = (T – G) Surplus and Deficit • • • If T>G, the government runs a budget surplus because it receives more money than it spends. The surplus of T-G represents public saving. If G>T, the government runs a budget deficit because it spends more money than it receives in tax revenue. Government Budget Deficits and Surpluses • • • Government borrowing to finance its budget deficit reduces the supply of loanable funds available to finance investment by households and firms. Interest rates rise and investment falls. This fall in investment is referred to as crowding out. The deficit borrowing crowds out private borrowers who are trying to finance investments. Government Budget Deficits and Surpluses A budget surplus increases the supply of loanable funds, reduces the interest rate, and stimulates investment. Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. The Effect of a Government Budget Deficit... Interest Rate S2 6% 5% 2. ...which raises the equilibrium interest rate... $800 $1,200 0 3. ...and reduces the equilibrium quantity of loanable funds. Supply, S1 1. A budget deficit decreases the supply of loanable funds... Demand Loanable Funds (in billions of dollars)